IS LIFE INSURANCE STILL RELEVANT IN 2013? Mary Ann Mancini, Esq. Loeb & Loeb LLP TABLE OF CONTENTS

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1 IS LIFE INSURANCE STILL RELEVANT IN 2013? Mary Ann Mancini, Esq. Loeb & Loeb LLP TABLE OF CONTENTS I. TRADITIONAL USES OF LIFE INSURANCE... 1 A. Wealth Replacement... 1 B. Business Uses... 1 C. Creditor Protection... 1 D. Provision for Lack of Marital Deduction... 1 II. INSURANCE AS AN INVESTMENT... 1 A. Private placement variable insurance policies B. Offshore variable insurance policies C. Life Insurance and the Net Investment Income Tax III. VALUATION OF LIFE INSURANCE POLICIES... 6 A. What is the fair market value of a life insurance policy for tax purposes?... 6 IV. LOANS TO TRUST HOLDING POLICY TO PAY PREMIUMS A. Description of premium financing of life insurance B. The Final Split Dollar Regulations and Loans C. Income Tax Consequences of Premium Financing Arrangements D. Will the loan be treated as bona fide debt for federal tax purposes? E. Does Federal Reserve Board Regulation U apply to insurance premium financing of variable policies? V. CHARITABLE GIFTS OF LIFE INSURANCE POLICIES A. There are a number of possible reasons to consider gifting an existing policy to a charity B. Considerations from the Charity s Perspective C. Income tax implications for the donor/insured D. The partial interest rule E. A gift of a policy subject to a loan F. Designation of a Charity as the Beneficiary of a Policy Owned by The Donor G. Insurance in a Charitable Trust VI. SELLING A POLICY A. Viatical and life settlements Page i

2 IS LIFE INSURANCE STILL RELEVANT IN 2013? Mary Ann Mancini, Esq. 1 Loeb & Loeb LLP Washington, D.C. September, 2013 I. TRADITIONAL USES OF LIFE INSURANCE A. Wealth Replacement B. Business Uses C. Creditor Protection D. Provision for Lack of Marital Deduction II. INSURANCE AS AN INVESTMENT A. Private placement variable insurance policies. 1. How it works A private placement life insurance policy is an individually tailored variable life insurance policy that is offered only to accredited investors. A minimum cash investment in the policy is typically required (sometimes as low as $1 million, sometimes as high as $5 or $10 million) initially or over the first few years of the policy s existence. Because private placement life insurance policies can only be offered to accredited investors, the cost of the policy and the agent commissions may be negotiated and are often much lower than off the shelf variable universal life policies and, as a result of these lower associated costs, private placement life insurance policies typically perform better than comparable off the shelf variable universal life policies. A private placement life insurance policy owner benefits from considerably broader investment options available under such policies. 2. Diversification rules under Section 817(h). a. Investments in variable life insurance contracts which are based on a segregated asset account must be adequately diversified as defined in Sec. 817(h) and the accompanying regulations in order for the earnings under the variable contract to accumulate on a tax-free basis. Specifically, investments of a segregated account are considered adequately diversified only if (i) one of three tests (described below and known as the general diversification test, the safe harbor test and the alternative test for variable life contracts ) are met, and (ii) the contract holder does not have investor control over the assets (and investor control, discussed 1 The author would like to acknowledge the important contributions of Lawrence Brody, Esq., and Caitlin Orr, Esq. to this outline.

3 below, is dominion and control over the assets sufficient to cause the contractholder, rather than the insurance company, to be treated as the owner of the assets for federal income tax purposes). i. The General Diversification Test 2 is satisfied if all of the following requirements are met: a. No more than 55% of the value of the total assets of the account is represented by any one investment; b. No more than 70% of the value of the total assets of the account is represented by any two investments; c. No more than 80% of the value of the total assets of the account is represented by any three investments; and d. No more than 90% of the value of the total assets of the account is represented by any four investments; requirements are met: ii. The Safe Harbor Test 3 is satisfied if both of the following a. The account meets the diversification requirements of a regulated investment company under Code Sec. 851(b)(3) and the associated regulations, and b. No more than 55% of the value of the total assets of the account are cash, cash items (including receivables), government securities and securities of other regulated investment companies; iii. The Alternative Test for Variable Life Contracts 4 is met if and to the extent that such segregated account is invested in securities issued by the U.S. Treasury, and such investments made by such account are treated as adequately diversified without regard to whether the General Diversification Test or the Safe Harbor Test are met. b. These rules require the separate asset accounts to be adequately diversified, as required by the above-described mechanical test. Section 817(h)(4) provides a lookthrough rule for Regulated Investment Companies ( RIC ). Under Reg. Sec , the lookthrough rule applies if all interests in the RIC are held by insurance company separate accounts and public access to the RIC is exclusively through an insurance policy. c. The second requirement for investments of a segregated account to be deemed adequately diversified is that the contractholder must not have investor control, meaning, essentially, that the contract must be considered an asset of the life insurance company that issues the contract, rather than an asset of the contractholder. In a series of revenue rulings issued over the past twenty-five years, the IRS has shed light on what constitutes investor control for purposes of adequate diversification. 2 Code Section 817(h)(1); Treas. Reg (b)(1). 3 Code Section 817(h)(2); Treas. Reg (b)(2). 4 Code Section 817(h)(3); Treas. Reg (b)(3). 2

4 (1) Generally speaking, investor control exists when the contractholder has the power to direct the life insurance company (or an agent thereof) to sell, purchase or exchange specific assets in a segregated account. Investor control will also likely be deemed to exist where the contractholder has some power that allows him/her to control or influence investment in a less direct way, for example, where the contractholder possesses the power to select investments, the power to change the terms of the investment guidelines, or where the contractholder retains any interest in the underlying assets themselves. (2) Further, the contractholder may be deemed to have investor control if he or she is able to communicate with the investment advisor regarding the investments of the segregated account or if he or she is seemed to have influence over the investment advisor s decisions. This issue is likely to arise if the contractholder s personal money manager as also serving as one of the managers of the funds offered under the policy. The contractholder will not necessarily be deemed to have investor control if he or she retains the power to allocate the premium payments and the cash value among broad categories of investment options, provided that the contractholder s retention of such power is consistent with the insurance provider being treated as the owner of the funds. In other words, to avoid having investment control, the contractholder can only choose from funds offered under the policy, and cannot choose or influence the choosing of investments. No whispering in the manager s ear. (3) Rev. Ruls and and the amendments to Reg. Sec (f) and (g) spell out the current IRS position. Only insurance only non-registered funds can be treated as pass-throughs to meet the diversification rules. This rule would retroactively apply to all variable policies, with no grandfathering. This change eliminates any arguable inconsistency between the diversification rules and the investor control rules. d. What is left after these developments? (1) Use of insurance dedicated funds. (2) A fund of fund manager offered only under the policy. (3) A clone fund of a publicly available fund. 3. These policies are more likely to be planned to be MECs, because the investment aspect of the policy is paramount. B. Offshore variable insurance policies. 1. Advantages. a. Lower costs. (1) No State premium taxes, lower entity taxes, no SEC compliance costs, etc., (to the extent these savings are passed along). Note that some states have reduced (or eliminated) their state premium tax. (2) Offset by the 1% premium excise tax, if the insured is a U.S. person and the carrier has not made a Section 953(d) election to be taxed as a U.S. carrier 3

5 U.S. investors. b. More investment choices. Including many not otherwise available to 2. Disadvantages. a. There is an increased risk of non-compliance with the life insurance and MEC definitions of the Code. Especially if the carrier isn t affiliated with a U.S. carrier. b. All policy sales activities (including solicitations, physicals, etc.) must take place off-shore. c. Carrier choices are limited. d. The owner must be an off-shore entity a corporation, partnership, trust, with the additional costs of creation and maintenance of the entity. C. Life Insurance and the Net Investment Income Tax. 1. Beginning on January 1, 2013, a new and separate income tax regime went into effect and applies against many trusts, as well as against individuals and estates. The Net Investment Income Tax, as it is called (hereinafter the NIIT ), is codified at Code Section 1411, which was enacted as part of the Health Care and Education Reconciliation Act of Treasury recently proposed regulations that provide guidance as to how this tax will be applied. The NIIT is required to be reported annually on the Form 8960, a draft of which has been developed by the IRS and was recently released to the public. 2. The NIIT applies at a rate of 3.8% to certain net investment income (described below) of individuals, estates and trusts that have income in excess of certain statutory threshold amounts. However, the statutory threshold amount applicable to trusts and estates is much lower than the statutory threshold amount applicable to individuals when determining NII subject to the new tax: a. An individual is subject to the tax on NII above an adjusted gross income threshold of $200,000 ($250,000 if married filing jointly). b. However, estates and trusts are subject to the tax on undistributed NII above the threshold level at which the top federal income tax rate begins, which is $11,950 in (Note that individual beneficiaries will be subject to the tax on distributed NII if their NII exceeds their own threshold for the NII tax.) Because the threshold level for trusts that must be reached before the NIIT will apply is so low, it is crucial that Trustees be made aware of the potential application of the tax and plan accordingly. 3. The NIIT is imposed on net investment income, which is comprised of three categories of gross income (referred to as gross investment income ), the aggregate amount of which is then reduced by specified NII deductions that are properly allocable to such gross income or net gain (described below). a. Specified income, which includes gross income from interests, dividends, annuities, royalties, rents and other passive income other than excluded business income (described below); 4

6 b. Covered business income, which is gross trade or business income that falls within one of these three sub-categories (and all other income derived in the ordinary course of a trade or business that is not described below is excluded business income, and is not subject to the NIIT): instruments or commodities, (1) Derived in the trade or business of trading in financial (2) Earned in a passive activity of the taxpayer within the meaning of Code Sec. 469, 5 and (3) Produced from the investment of working capital; and c. Covered gain, which is net gain (to the extent taking into account in computing taxable income) from dispositions of property other than gain comprising excluded business income. 4. Exclusions: Specific types of income are specifically exempted from the NIIT under Code Sec. 1411, including: a. Employment income and compensation (which are subject to the hospital insurance Medicare tax and, therefore, are not subject to the NIIT); b. Qualified plan distributions; and c. Income excluded from taxable income (such as tax-exempt interest on state and municipal bonds, life insurance proceeds, and deferred or excluded gain such as that from a like-kind exchange or the sale of a personal residence) 5. NII Deductions: Deductions that can be used to reduce NII include: a. investment interest expense, b. investment advisory and brokerage fees, c. expenses related to rental and royalty income, and net investment income. d. state and local income taxes properly allocable to items included in 5 Note that Congress adopted the passive activity loss rules, including the material participation concept, for determining the NIIT under Code Sec Thus, the discussion above regarding the ambiguity in the law regarding how material participation is determined for trusts under the passive activity loss rules takes on even greater importance this year as those same rules will apply to determine the amount of undistributed income of a trust that is subject to the NIIT. Note also that, prior to enactment of the NIIT, income classified as passive activity income was generally favored by taxpayers, as it could be used to offset passive activity losses to the extent they existed. However, now that passive activity income will be subject to the 3.8% NIIT, taxpayers may desire to convert passive income into non-passive income to the extent it is not needed to offset passive activity losses. 5

7 6. Three Step Computation of the NIIT of a Non-Grantor Trust 6 a. Step One: determine adjusted gross income, as defined under Code Section 67(e), for the taxable year. AGI for a trust is the same as for an individual, except that Code Sec. 67(e) permits three additional deductions for (1) administration expenses unique to the fiduciary arrangement, (2) the distribution deduction, limited to DNI, and (3) the trust s personal exemption. If the trust s AGI exceeds the applicable threshold amount, the Trustee will need to move on to Step Two. b. Step Two: determine undistributed NII, which is equal to a trust s net investment income (as described above) less any distributions of NII made to beneficiaries under Code Sections 651 and 661 and by deductions for amounts set aside for a charitable purpose under Code Sec c. Step Three: apply the 3.8% tax rate to the lesser of the two numbers derived under steps one and two. 7. Investment Planning Opportunities. a. Barring any Congressional action changing the manner in which the NIIT applies to trusts and estates, as a result of the disparate application of the NIIT to trusts and estates versus application thereof to individuals, Trustees will likely feel more pressure (and may be more inclined now than in prior years) to distribute net investment income to its beneficiaries to avoid imposition of the NIIT. This plan, however, may not be what the Settlor of the trust intended and exposes such assets to the creditors of the recipient beneficiary or the beneficiary may not be able to handle the funds responsibly. b. Alternatively, Trustees may aim to reduce the trusts net investment income by reducing its passive activity income or by employing a new investment strategy for the trust that will allow the trust to avoid generating net investment income. c. A trustee may consider acquiring a life insurance policy that has investment features and taking advantage of the income-tax free build up in such a policy to handle some of its investing that would otherwise give rise to NII, however, the trust s insurable interest in the insured for such policy may be an issue. III. VALUATION OF LIFE INSURANCE POLICIES A. What is the fair market value of a life insurance policy for tax purposes? 1. There are different methods of valuing policies based on the reason the policy is being valued. a. Income tax transactions involving policy valuation. 6 Grantor trusts are disregarded for purposes of the NIIT, and the NIIT on grantor trusts is computed as the same manner as the NIIT is computed for individuals. (Prop. Reg. Sec (b)(5)). Note also that special computational rules apply for charitable remainder trusts and electing small business trusts, which rules can be found in the proposed regulations. 6

8 (1) The purchase or transfer of a policy out of a qualified plan or the purchase by an employer of a policy that will be transferred to an employee (upon retirement or after a period of employment). (a) When these transactions were planned in the past, the value of the policy, by design, was artificially low at the time of the transaction, usually by imposing large surrender charges in early years, which would disappear sometime after the transfer ( springing cash value policies) or by purchasing a policy with high initial costs and exchanging it after the transfer. (b) See Notice and Announcement both warning that such springing cash value policies distributed out of qualified plans couldn t be valued using their cash surrender value. (c) Prior to this Notice, taxpayers followed Rev. Rul , 9 the IRS held that a policy s value for income tax purposes should be determined consistent with its gift tax valuation under the Section 2512 Regulations, described below. (d) The Section 83 Regulations had long provided that the fair market value of a policy transferred as compensation was its cash surrender value. (e) Proposed Regulations were issued in 2004 amending the Section 402, 83 and 79 regulations and a series of rulings, all requiring the use of the fair market value of a policy, rather than its cash surrender value, in valuing transfers of policies in those situations. 10 automatically be accepted by the Service. (i) These are safe harbor values which will (ii) Under the Section 83 proposed regulations, the policy cash value (not surrender value) plus all other rights in the policy are treated as property the same definition as under the final split-dollar regulations. (iii) Under the Section 402 proposed regulations, the policy s fair market value must be used for distributions or sales of policies to participants. (iv) Under the 2004 temporary safe harbor rules, the fair market value of a policy can be approximated by using its cash value (ignoring surrender charges), if it is at least equal to all premiums paid plus earnings credited (investment results for variable policies), less reasonable mortality and other charges C.B I.R.B I.C.B See Prop. Regs , Rev. Ruls and 21. See also, Rev. Proc , C.B. 559, revised by Rev. Proc , C.B. 962, providing safe harbor rules; the 2004 safe harbors apply for transfers between 2/13/04 and 5/1/05, and the 2005 safe harbors apply for all periods (including those before 5/1/05). 7

9 (v) The preamble to the proposed regulations also warned that, for gift tax purposes, under the long-standing Section 2512 regulations, the unusual nature of a policy (an undefined term) can prevent the use of the usual replacement cost approximation of the interpolated terminal reserve formula, the ITR value, if that approximation isn t reasonably close to full value (another undefined term). (f) Under the 2005 permanent safe harbor rules, the fair market value of a policy is the greater of the ITR value (adjusted for unearned premiums) or what is called the PERC amount - Premiums plus Earnings minus Reasonable Charges (adjusted by an interest factor for Section 402 purposes). (i) The PERC amount is aggregated premiums plus dividends plus earnings minus reasonable charges and distributions. (ii) Final regulations under Sections 79, 83, 401 and 402 were issued on August 29, 2005, effective on that date, but applicable to policy transfers or distributions on or after 2/13/04, which adopted the provisions of the proposed regulations in all relevant aspects. (iv) The preamble to the final regulations contains the same warning about gift tax valuation for transfers of unusual policies. b. Gift tax transactions involving policy valuation. (1) The gift tax valuation of a policy is set out in Reg. Sec (a), which was written when there traditionally was no market for life insurance policies and was based on early Supreme Court cases dating from the 1940s. 11 (a) The regulation states that the fair market value of a policy for gift tax purposes (and presumably for (a) income tax purposes under Rev. Rul [unless the 2005 Regulations discussed above apply] and (b) estate tax purposes 12 ), is the cost of a comparable policy. premium paid. replacement cost. 13 (b) (c) For a new policy, its gift tax value would be the For a single premium policy, its gift tax value is its (d) For a more usual policy on which further premiums are due and which has been in force for some time (an undefined term), since replacement cost would 11 See, Guggenheim v. Rasquin, 312 U.S. 254 (1941) (dealing with a single premium policy gifted when the premium was paid) and U.S. v. Ryerson, 312 U.S. 260 (1941) (dealing with a similar policy gifted later). 12 Reg. Sec (a) (2), the estate tax analog of Reg. Sec (a) for valuing a policy on the life of another owned by the decedent). 13 But See Rev. Rul , C.B. 280, concluding that since there was no comparable contract providing the same economic benefits (the entire bundle of rights provided in the original policy), the I.T.R. approximation of the Section 2512 Regulations, had to be used. 8

10 be hard to determine, the regulations provide that its gift tax value can be approximated by the policy s interpolated terminal reserve ( ITR ) plus any prepaid premiums. 14 (e) The type of policy and the insured s health are not relevant considerations in the ITR determination. (2) Interpolated Terminal Reserve (a) Note that the ITR concept only realistically applies to traditional whole life policies (which were the only kind of permanent policy available when the Regulations were adopted), where policy values are guaranteed to increase at stated intervals during the life of the policy. ITR is, however, used as the method of valuation for universal, no lapse guarantee, and variable life policies as well (in which there are no guaranteed increases in the cash surrender values). (b) Reserves: (i) Note the potential effect of a shadow account used in a no-lapse guarantee universal life policy which can increase the policy s ITR (even when cash values are low or even non-existent). (ii) Note that some carriers calculate the reserve for such policies using what is known as a deficiency reserve and some don t the reserve calculation without a deficiency reserve should be lower. (ii) Which reserve does the carrier use in determining the ITR the reserve value for the policy used in determining its income tax liability or the statutory reserve for the policy filed with the state insurance department? the carrier s books which will impact value. (iv) For level term policies, there is a reserve on (c) Form 712 (i) The practice of carriers in reporting values on Form 712 is apparently not consistent, with some only reporting the ITR and some others reporting the policy cash value or its statutory reserves. (ii) Some carriers have begun providing a series of values, leaving the determination (which they take the position is a legal issue) up to the adviser. (iii) The instructions to Form 712 indicate that for single premium or paid-up policies, the amount shown on the Form may not be relied on where the surrender value of the policy exceeds its replacement cost. (3) Reg. Sec (a) also provides that if, due to the unusual nature of the contract (an undefined phrase) the regulation formula doesn t reasonably 14 See, eg, Rev. Ruls , C.B. 188 (holding that a policy that had been in force for seven years had been in force for some time ) and , C.B. 321 (reaching a similar conclusion for a policy which had been in force for only three years). 9

11 approximate its full value (also an undefined phrase), it may not be used (with no indication of what may be used instead). (a) Consider whether this phrase limits the use of the ITR formula to only traditional whole life policies. (b) See Pritchard v. CIR, 15 holding that normal policy gift tax values don t apply if the insured is near death (an undefined term) -- at that point, fair market value approaches the full face value. (c) See also PLR , holding the policy s gift value controls for a gift of a survivorship policy, so long as the insureds aren t near death. (4) Two alternative methods of valuation would be the market (life settlement values) and an independent appraisal. (a) A gift of a policy worth more than $5,000 to charity requires an independent appraisal, under Section 170(f)(ii)(c). (b) Establishing the market is difficult. Does it matter if a settlement offer has been received? What if the policy would qualify for a settlement, but no offers were solicited? (5) Should practitioners request all possible values for a policy before deciding what value to use for reporting the transaction? 2. What is the value of a policy sold to avoid Section 2035 (under its full and adequate consideration exception)? Is it the policy s gift tax value or the amount necessary to replace it in the insured s estate for estate tax purposes, which would be the face amount of the policy. a. Allen v. U.S. 16 held that when a person with a retained interest in a trust (a life estate) the existence of which would cause the entire trust to be includable in the person s estate, sold the life estate for its actuarial value, the sale was not for full and adequate consideration as required under Section 2035 and therefore, upon the person s death within three years of the sale, the entire value of the trust was includable in the person s estate. The court held that Section 2035 was designed to ensure that the taxable estate of the decedent would be the same amount, whether or not a sale for full and adequate consideration took place within three years of death (since the sale proceeds would be equal to the value of the asset, if the asset had not been sold). b. In PLR a corporation sold a policy on the life of the controlling shareholder for its reserve value (not the face amount) two years prior to the shareholder s death and the IRS held, citing Allen v. U.S., that the death benefit of the policy was includable in the shareholders estate under Section 2035, since the sale was not for full and adequate consideration. c. In PLR , the IRS held that when trusts holding second to die life insurance policies (trusts through which the insureds held incidents of ownership under Section 2042(2) in the policies) sold the policies to another trust for an amount equal to the policies 15 4 T.C. 204 (1944), F. 2 nd 916 (10 th Cir. 1961) 10

12 interpolated terminal reserve, that sale was for full and adequate consideration for purposes of Section At that time, however, both insured s were alive and if one of them had died, what would have been included in such insured s estate (had no sale taken place) is the value of the policy, not the death benefit, since the second insured would still be alive. IV. LOANS TO TRUST HOLDING POLICY TO PAY PREMIUMS A. Description of premium financing of life insurance. 1. Generally, the insured, as grantor, will create an irrevocable insurance trust to become the owner of a new policy on his or her life (or on the lives of the grantor and his or her spouse on a survivorship basis). The insurance trust will pay all or a portion of the premium payments due on the policy with funds that it borrows (the lender could be a family trust, the grantor or the grantor s spouse, or LLC or a completely unrelated lender, such as a bank). The trust will pay interest on the loan usually with funds received directly or indirectly from the grantor, either as part of the initial trust funding or as annual gifts; the principal of the loan will be repaid at the end of the term of the loan or at the insured s death. If the loan is from a third party, the grantor might guarantee the third party s loans to the trust and/or pledge assets as security for its loans. 2. The transaction could be a series of loans as each premium comes due, or one large loan designed to cover all future premiums (with growth assumptions built into the amount) or to cover a single premium policy. The second alternative allows the grantor to capture current low interest rates. 3. A more complicated alternative involves the insurance trust acquiring both the policy and an annuity, both on the insured s life (from different carriers) and borrowing the single premium for the annuity. The annuity payments would pay the premiums on the insurance policy. B. The Final Split Dollar Regulations and Loans. 1. The final split-dollar Regulations define a split-dollar arrangement as one between an owner and a non-owner of a life insurance contract, pursuant to which either party pays all (or a part) of the premiums and at least one party is entitled to recover all or a portion of those premiums and that recovery is to be made from or is secured by the proceeds of a policy. a. Loans used to pay premiums that are secured by the policy (premium financing arrangements) are included in this broad definition, although, in most cases, so long as interest is paid (or accrued) at the AFR, the general tax rules governing loans, and not the special split-dollar loan rules of the final Regulations, will apply. b. However, as described below, there are special rules for loans with interest paid at the AFR where the lender is to pay the interest to the borrower, for interest which is forgiven, and there are special filing requirements for non-recourse loans, as well as payment ordering rules, all of which could apply to premium financing transactions (especially those where the grantor, his or her spouse, or a controlled entity is the lender). 2. If a payment made under a split-dollar loan is non-recourse, Reg. Sec (j) treats the loan as a loan that provides for contingent payments (increasing the complexity of calculating the tax consequences and testing for the adequacy of interest), unless the parties to the arrangement provide a written representation with respect to the loan that indicates that a reasonable person would expect all payments under the loan to be made. 11

13 a. The word non-recourse is not defined in the Regulations; it isn t clear if it is broad enough to mean a recourse loan to a trust with no assets other than a policy. b. The Regulations require that, subject to future IRS rules, that representation be attached to both parties tax returns for each year such a loan is made. 3. The Regulations ignore the stated interest on a loan document (which would cause the loan to be considered a below-market split dollar loan), if all or a portion of the interest is to be paid directly or indirectly by the lender or a person related to the lender. a. The result would be imputed interest as well as possibly reclassification of the loan as a hybrid loan under the split dollar Regulations that, if considered a term loan, will have gift tax consequences equal to the present discounted value of all imputed interest for the term deemed to be transferred to the borrower at the outset of the loan. b. A facts and circumstances test will be used to determine if the interest is to be paid by the lender; there is no definition in the Regulations of the phrase to be paid. c. The example in the Regulations provide that amounts to be paid by an employer under a fully vested non-qualified deferred compensation arrangement that will pay the employee an amount of the interest due under the split-dollar loan will be disregarded. However, a fully vested non-qualified deferred compensation arrangement that provides for payment equal to the employee s salary, which the facts and circumstances show is not related to the employee s interest obligations, will not be disregarded. 4. The split dollar Regulations also provide that stated interest that is waived or forgiven by the lender will be treated as transferred from the lender to the borrower and is subject to a deferral charge equal to the underpayment of tax interest penalty. a. If the loan is a nonrecourse loan where the parties have made the representation described above, then if interest is waived or forgiven, the amount forgiven or waived will still be considered transferred from lender to the borrower, but no deferral charge will be imposed. This is another reason for the parties to execute the representation. 5. Finally, the split dollar Regulations also provide that when repaying a series of loans, the repayment must be in the order the loans were made. So there is no ability to pay off loans with higher interest rates first. C. Income Tax Consequences of Premium Financing Arrangements. 1. The income tax consequences of these transactions are dependent upon whether the trust (or a portion of the trust) is classified for income tax purposes as a grantor trust or a non-grantor trust. If the grantor is the lender and the borrower/trust is a grantor trust, then the arrangement is ignored for income tax purposes. a. A grantor trust power that is unique to trusts holding insurance: the Section 677(a)(3) power. (1) Under Section 677(a)(3), the grantor of a trust is treated as the owner of any trust (or a portion of any trust) as to which the grantor or a non-adverse party may 12

14 apply trust income to the payment of premiums on policies of insurance on the life of the grantor or the grantor s spouse. (2) The Sections raises certain questions: (a) Does the term income in this Section referring to fiduciary accounting income or taxable income? Fiduciary accounting income does not usually include capital gains, a principal item. (b) Is it sufficient that the trust may pay the expenses out of taxable income to cause the trust to be a grantor trust, or must it in fact pay such premiums out of such income (and not principal that is not taxable income)? (c) trust? Is the trust only partially a grantor trust? What if the premiums are less than the income of the (3) While trust provisions preventing trust income from being used to pay insurance premiums would seem to make Section 677(a)(3) inapplicable to such an insurance trust, there is very little authority on this issue, and much of the authority which does exist is based on the predecessor to Section 677(a)(3). (a) The Service will not issue private letter rulings regarding the status of irrevocable insurance trusts where the trustee has the power to use trust income or principal to pay premiums on policies insuring the grantor s life. (b) Ltr. Rul raises the issue of whether an insurance trust can ever be treated as a non-grantor trust. There, grantors, husband and wife, created two irrevocable trusts that did not, at that time, own, nor pay premiums on, any life insurance policies on the life of either grantor. The trust instruments provided that Trust income shall not be applied toward the payment of insurance premiums for policies on the life of any contributor to Trust. Further, any undistributed income was to be accumulated and added to corpus. Several years later, each trust purchased a survivorship policy on the lives of the grantors, paying the single premium out of the trust principal. The amount of the premium exceeded each trust s total taxable income for that year. (i) In ruling on whether these trusts were grantor trusts under Section 677(a)(3), the Service began by drawing a distinction between trust accounting income and income as determined for tax purposes. (ii) The Service concluded that the trust instrument prevented only the use of trust accounting income from being used to pay premiums, but that the source of premium payments for trust accounting purposes is immaterial for purposes of Section 677(a)(3). Therefore, because the amount paid for the insurance premium exceeded the taxable income of each trust during the year the policies were purchased, the grantors were treated as owners of the entire taxable income of the trusts for that year. (iii) If Congress in enacting Section 677(a)(3) had intended for the source of premium payments to be immaterial, it could have written Section 677(a) to apply to both trust income and corpus, rather than just income, as it did in Section 677(b) where it states that to the extent that the grantor s legal obligation of support is paid out of corpus or 13

15 out of other than income for the taxable year, such amounts will be taxed to the grantor under Section 662 and not under the grantor trust provisions. (iv) The courts have generally restricted attempts by the Service to expand the predecessors of Section 677(a)(3). While most of the cases interpreting the predecessor to Section 677(a)(3) date from the 1930s and 1940s, they are helpful in interpreting Section 677(a)(3) because of the relatively minor differences between Section 677(a)(3) and its predecessors. In these cases, there were three variables that determined the results in the case law under the predecessors of Section 677(a)(3), namely (1) the ability of the trustee to use trust income to pay premiums; (2) whether the trust held an insurance policy on the life of the grantor; and (3) whether the trustee actually paid premiums on such an insurance policy out of the income of the trust. (v) The easiest cases to resolve were those where: (1) the trustee was not prohibited from using trust income to pay premiums, the trust owned an insurance policy on the grantor s life, and the trustee paid premiums on that policy out of the trust income, and those where (2) the trustee was prohibited from using trust income to pay premiums, the trust did not own an insurance policy on the grantor s life, and the trustee did not pay premiums on that policy out of the trust income. These two cases fall directly inside or outside, respectively, the scope the predecessor of Section 677(a)(3). (vi) If a trust were to allow the trustee to pay premiums on and were to hold an insurance policy on the grantor s life, but not pay premiums on it out of the trust income, then under the holding of Chandler v. Comm r 17, the trust would not be a grantor trust under Section 167(a)(3). There, the trust instrument provided that premiums should be paid out of trust income only to the extent not paid by insurance policy dividends and contributions from the grantor. If the income had been used to pay the premiums on the insurance policy held by the trust, that income would have been taxable to the grantor, but since no income was used to pay the premiums, the court held Section 167(a)(3) did not apply. (vii) A trust that granted the trustee the ability to pay premiums but which neither held an insurance policy on the grantor s life nor used its income to pay premiums will not be considered a grantor trust under Section 167(a)(3). This situation arose in both Moore v. Comm r 18 and Weil v. Comm r 19, in which the Service attempted to extend the application of Section 167(a)(3) to trusts that simply allowed for trustees to pay premiums on insurance policies, regardless of whether the trusts actually held insurance policies or paid any premiums. In Moore, the trust instrument provided that the trustee may invest in and/or pay the premiums on policies. In Weil, the trust provided that the net income of the trust property should be used to pay the premiums on policies. In neither case did the trusts hold insurance policies or pay premiums. (viii) In Rand v. Comm r 20, the court considered the situation where the trust owned an insurance policy and the trustees paid premiums on the policy out of trust income, even though the trust did not specifically allow for the payment of premiums out F.2d 623 (3 rd Cir. 1941) B.T.A. 808 (1939), acq., C.B T.C. 579 (1944), acq., 1944 C.B B.T.A. 233 (1939), acq., C.B. 30, aff d, 116 F.2d 929 (8 th Cir. 1941), cert denied, 313 U.S. 594 (1941). 14

16 of income. The taxpayer argued that, although nothing under state law prohibited a trustee from investing in life insurance and the trust was silent on this issue, the use of trust income to pay insurance policy premiums was not authorized by the trust instrument and was therefore a breach of trust. The court found this result inconceivable, noting that the taxpayer was both grantor and trustee and that it was unlikely that the taxpayer, as trustee, would administer the trust against the wishes of the taxpayer, as grantor. The court concluded that, even where a trust was silent as to whether income could be used to pay premiums, Section 167(a)(3) dictated grantor trust status for a trust that held an insurance policy on the grantor s life, the income of which was used to pay premiums. (ix) Finally, there is a question as to how a trust will be treated under Section 677(a)(3) if it owns an insurance policy on the grantor s life, the trustees are specifically prohibited from paying premiums out of trust income, and no such premium payments are made out of the trust income. As discussed above, Chandler, Moore and Weil can all be read to stand for the proposition that a trust is a grantor trust only to the extent that trust income is used to pay premiums on an insurance policy on the life of the grantor. In addition, Rand indicates that whether a trust expressly provides the trustee with the power to pay premiums out of trust income is immaterial. The court in Rand also seemed to imply that even if the trust specifically prohibited the use of income for the payment of premiums, the breach of trust by the trustee who uses trust income to pay premiums would not prevent grantor trust treatment for the trust under Section 167(a)(3). (c) Accordingly, the case law applying Section 167(a)(3) is in conflict with the Service s position in Ltr. Rul Although, in the ruling, the Service tried to eliminate the distinction between principal and income under Section 677(a)(3) by creating a trust accounting income and taxable income dichotomy, the general weight of the prior case law is that the trust must own an insurance policy on the life of the grantor and the premiums on that policy must be paid out of the trust income during the taxable year in order for the trust to be considered a grantor trust. The assertion that it is immaterial whether the payments were actually made out of income or principal, so long as the amount of the payments exceeded the taxable income of the trust, is an excessively broad reading of Section 677(a)(3) in light of the substantial precedents under the predecessor to Section 677(a)(3) holding to the contrary, as well as a literal reading of the statute. Section 677(a)(3). (4) Drafting to avoid grantor trust status under (a) Draft the trust agreement so that either income is automatically distributed to the beneficiaries upon receipt, or so that income is segregated in a separate accrued income account and is prohibited under the terms of the trust from being used to pay premiums on policies on the grantor s life (or his or her spouse). To the extent that Ltr. Rul is correct with regard to its taxable income versus trust accounting income dichotomy, any prohibition on the use of trust income, or any automatic distribution of trust income, should be drafted in such a way that the income to which the prohibition or distribution applies is the taxable income of the trust. (b) Require that any discretionary use of trust income to pay premiums on a policy on the life of the grantor or his or her spouse be consented to by an adverse party a trust beneficiary whose interest would be effected by such a use of trust income. (c) See Ltr. Ruling which addressed a CRT holding life insurance and avoiding Section677(a)(3). 15

17 b. Another grantor trust power that causes an issue for a trust holding an insurance policy. (1) If it is important to be sure the entire trust will be treated as a grantor trust for income tax purposes, adding an additional grantor trust power, which would not be estate tax sensitive, should be considered and one such commonly used grantor trust power is the administrative power to reacquire trust assets by substituting assets having an equivalent fair market value, held in a non-fiduciary power (by the grantor or by any other presumably, non-adverse person). The court in Jordahl v. CIR 21 held that such a power held by the grantor-insured was not an incident of ownership in the policy owned by the trust for purposes of Section 2042(2). In Jordahl, however, that power was held in a fiduciary capacity; would the court find the same way for a power held in a non-fiduciary capacity? 22 (2) Rev. Rul held such a power of substitution would not be a Section 2036 nor a 2038 power, so long as the trust instrument or local law required that the trustee has a fiduciary duty to ensure that the properties are, in fact, of equivalent value, and the substitution power cannot be exercised so as to shift beneficial interests. The ruling did not, however, refer to Section (3) Rev. Rul extended the holding of Rev. Rul to section 2042, which should put that issue to rest, so long as the power is similarly limited. 2. Income tax consequences on the termination of the trust s status as a grantor trust (either at the grantor s death or during his or her lifetime) since the Trust has a loan payable to the Grantor in the Transaction. a. The trust will cease to be a grantor trust upon the death of the grantor, or upon termination of the power(s) which caused it to be treated as a grantor trust during the grantor s life. As a result, the trust will no longer be disregarded for income tax purposes, and instead will be treated as a separate taxable entity. (1) Upon the termination of the trust s grantor status during the grantor s lifetime, the termination of that status will be treated as a sale of the policy by the grantor for the outstanding loan. That deemed sale would generate gain under Section 1001 Regulations, to the extent the outstanding liability exceeded the grantor s basis in the policy. (a) Under the general rule of Treas. Reg. Section (a)(1), the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of such sale or disposition; in this case, the trust s deemed assumption of the grantor trust s loan by the new non-grantor trust will be treated as a discharge of the grantor s liabilities in consideration for the assets (the policy) that the grantor is deemed to have transferred to the new non-grantor trust. (b) However, Treas. Reg. Section (a)(3) provides an exception to this rule when a liability is incurred for purposes of acquiring property and is TC 92 (1975). 22 See also Ltr. Ruls and

18 not taken into account in determining the transferor s basis in such property (for example, where the loan is between the grantor and the trust and thus is ignored for income tax purposes under Rev. Rul ). Under these circumstances, the assumed liability will not be included in the amount realized by the transferor and therefore will not cause recognition of gain. (i) Example 5 of Treas. Reg. Section (c) illustrates what is deemed to occur on termination of grantor trust status during the grantor s life. In the Example, a grantor was considered to be the partner of a partnership in which the grantor trust held an interest. Upon termination of grantor trust status on the renunciation of a grantor trust power, a constructive transfer of the partnership interest to the trust was deemed to occur. The Example concludes that the grantor is required to recognize gain to the extent the allocable share of partnership liabilities assumed by the trust exceeds the grantor s basis in the partnership interest. (ii) Similarly, in Madorin v. Commissioner 23, a grantor transferred to a grantor trust an interest in a partnership that held encumbered assets. The grantor deducted the net losses from the partnership until the trustee renounced a power that had caused the trust to be a grantor trust. The court held that the grantor was released from his share of the underlying liabilities and recognized a gain to the extent that these liabilities exceeded the basis of the partnership interest. discussed below under Rev. Ruling (iii) See the issue with the Grantor s basis (c) In applying the general rule of Treas. Reg. Section (a)(1) to a premium financing transaction, on the termination in status of the trust as a grantor trust, the grantor will be deemed to have transferred the life insurance policy to the trust in exchange for the trust s assumption of the loan incurred in connection with the trust s acquisition of the policy. Under the general rule, the grantor will realize income to the extent the liability (i.e., the amount of the loan on termination of the trust s grantor trust status) assumed by the trust exceeds the grantor s basis in the policy. If the exception of Treas. Reg. Section (a)(3) applies, because the liability (the loan) was incurred in connection with the acquisition of the policy and is not taken into account in determining the grantor s basis in the policy which would be true of a loan between a grantor and his or her grantor trust then no income will be realized by the grantor on termination of the trust s grantor trust status, even if the liability deemed assumed by the trust exceeds the grantor s basis in the policy. (2) There is even less certainty about the income tax consequences of termination of grantor trust status as a result of the death of the grantor, where the trust has outstanding liabilities (to the grantor or to a third party). (a) Some commentators believe that the grantor s death has no tax consequences; under that analysis, death is not an event that triggers gain recognition. Another possible result, and the one which the IRS would likely endorse, is that the income tax consequences on the death of the grantor follow those that are deemed to occur when grantor trust status is terminated during the grantor s life, as set forth in the regulations under Section 1001 and other authorities. Under that analysis, the income tax consequences would be the same whether termination of grantor trust status is a result of the grantor s death or a termination of the applicable grantor trust power(s) during the grantor s life T.C. 667 (1978). 17

19 (b) The other open issue here is when the transfer takes place at the moment of, the moment before, or the moment after the event ending grantor trust status, in this case, the insured s death. There isn t any direct authority on this issue, but there is an arguably analogous area the termination of grantor trust status of a foreign trust taxed under Section 679. There, on the one hand, Reg. Sec (c)(2), provides that the deemed transfer there takes place the moment after grantor trust status ends, but on the other hand, Reg. Sec (e) provides upon the death of the grantor, he or she is treated as having transferred the property to the trust immediately before death. In the transfer for value situation, it would seem that, if that the rule is that the policy would be deemed to be transferred after death, there would not have been even a deemed transfer of the policy during the insured s life. (3) One issue that may arise upon the termination of the trust s grantor trust status and the resultant deemed transfer of the policy in exchange for the release of the grantor's liability, is that a transfer for value of the policy under Section 101(a)(2) has occurred upon such transfer when the grantor trust becomes a non-grantor trust. If a policy is transferred for value, the amount includable in taxable income is the death benefit minus (i) actual value of any consideration received (in this case, relief from the liability), and (ii) premiums and other amounts subsequently paid by transferee (which, in this case would not occur). (a) Under the transfer for value rules of Section 101(a)(2), life insurance proceeds in excess of the owner's investment in the contract will be taxed as ordinary income if there has been a transfer of the policy or any interest in the policy for valuable consideration. (b) Transfers for value include the sale of the policy, the transfer of rights to the policy proceeds for consideration and transfers of policies subject to loans. Transfers are broadly defined under this Section, but it isn t clear that they are so broadly defined as to include a deemed transfer for income tax purposes that does not involve a physical transfer of an interest in a policy this deemed transfer does not change who will benefit from the policy proceeds, which is the concern which underlies the transfer for value concept. 24 (c) There are five exceptions under Section 101(a)(2). If a policy is transferred for valuable consideration, but the transfer fits within one of these exceptions, the death benefit will not be subject to income tax. Only one of the five exceptions would be applicable in the context of a deemed transfer that would occur when a grantor trust becomes a non-grantor trust and the non-grantor trust is obligated on a note. If the basis in the hands of the recipient (the non-grantor trust) is determined, in whole or in part, by reference to the original owner's basis (the grantor trust), the transfer for value rules will not apply. This exception can protect partsale, part-gift situations where the transferor's basis (the grantor's basis in the assets held in the grantor trust) is greater than the consideration paid by the transferee (the amount of the liability). Tax-free transactions, such as contributing policies to an entity, transfers to spouses under Section 1041, and transfers in a tax-free corporate reorganization will also be protected. 24 See PLR , which held that where a partnership was terminated for tax purposes because 50% of the partners (who would have benefited from the proceeds) changed, there was a transfer for value of its policies; here, however, there is no change in the trust beneficiaries as a result of the grantor s death. 18

20 (d) If a previously tainted policy (considered transferred for value) is subsequently transferred under one of the five exceptions to the transfer for value rules exceptions, it can lose its taint. 25 the trust as a non-grantor trust. (4) For these reasons, consideration should be given to creating 3. Estate tax consequences of premium financing a. In Ltr. Rul , the Service considered the implications of a private split-dollar arrangement between a husband and wife as the premium providers and their irrevocable insurance trust, with respect to a policy insuring the lives of the husband and wife, on a survivorship basis. (1) The premium providers initially funded the trust with a cash gift, with which the Trustee purchased and paid for the first premium on a survivorship policy covering their lives. The trust was named as initial owner and beneficiary of the policy. Under the proposed collateral assignment split-dollar agreement, the Trustee was designated as the owner of the policy. The trust would pay the smaller portion of the annual policy premiums and the insureds would pay the balance of the annual premium. The split-dollar agreement was terminable at will by either the Trustee or the insureds, so long as the value of the trust assets (based on the loan value of the policy) equaled or exceeded the amount to be repaid to the insureds on termination of the arrangement. In all other cases, the agreement could be terminated only by mutual consent of the Trustee and the insureds. The agreement would also terminate upon the bankruptcy of the insureds, failure of the Trustee to reimburse the insureds, failure of the insureds to pay their share of the premiums, or the death of the survivor of the insureds. If the agreement terminated prior to the death of the survivor of the insureds, the survivor would be entitled to receive an amount equal to the cash value of the policy, net of the cash surrender value at the end of the initial policy year. If the agreement terminated as a result of the death of the survivor of the insureds, the estate of the survivor would be entitled to receive an amount equal to the cash value of the policy immediately prior to the survivor s death, again, less the cash surrender value at the end of the initial policy year. In order to secure the insureds interest in the policy, the Trustee assigned to the taxpayers limited rights under a restricted collateral assignment. The only rights assigned to the insureds were the right to receive a portion of the death proceeds payable on the survivor s death and the right to receive the cash value of the policy if the policy were surrendered by the Trustee. All other rights under the policy were reserved to the Trustee under the collateral assignment. (2) One of the issues on which the Service was asked to rule was whether the insurance proceeds payable to the trust under the split-dollar agreement would be includible in the gross estate of the surviving insured. The Service held that the insureds retained no incidents of ownership in the survivorship policy on their lives, as a conclusion, and without any analysis. Although the ruling discusses the broad nature of the phrase incidents of ownership under the Section 2042 regulations, the ruling goes on to apparently hold that the restricted nature of the collateral assignment to the insureds was enough to prevent their interest in the policy from rising to the level of an incident of ownership in the policy. Thus, even though the insureds had a security interest in the policy (although with few of the rights which would normally be granted a secured creditor), they were not deemed to hold any incidents of ownership in the policy which would cause its inclusion in either of their estates under Section Similarly, the insured s guarantee of a loan 25 Treas. Reg. Section (b)(2) and (3). 19